Private capital inflows can bring substantial benefits to an economy, including by boosting private sector activity and enhancing economic growth prospects. In particular, foreign direct investment (FDI), generally considered the most resilient form of capital inflows, is also associated with the transfer of new technologies and skills and improved market access. Unlike most other emerging markets, however, capital flows to South Africa since the mid-1990s have been heavily biased toward portfolio flows. A new IMF cross-country study seeks to identify the main determinants of the level and composition of South Africa’s capital inflows and suggests that further trade and capital account liberalization would increase the share of FDI. It also finds that exchange rate volatility tends to deter FDI but has little impact on foreign portfolio flows. Faisal Ahmed and Norbert Funke, of the IMF’s Policy Development Review and African Departments, respectively, spoke with Jacqueline Irving of the IMF Survey.
IMF Survey:Why is the composition of capital flows to South Africa biased toward portfolio investment flows?
Funke: South Africa attracts as much or even more combined FDI and foreign portfolio flows taken together as do other comparator emerging market countries—on average 5 percent of GDP annually over 1994–2002. But the proportion of inbound FDI is much less than for comparator countries, and the share of foreign portfolio investment is much higher.
To understand why, our cross-country study looked at both common and specific determinants of FDI and foreign portfolio flows. Our findings suggest that during 1975–2002 South Africa scored lower than its major competitors for capital flows in growth and infrastructure—two important determinants of FDI. Exchange rate volatility also was substantially higher than for comparator countries. Moreover, although South Africa has gradually relaxed capital controls over the past 10 years, it retains some controls, including a requirement that exporters repatriate their export proceeds within six months. And because South Africa is the largest financial market in Africa, it is very attractive to portfolio investors seeking to diversify their portfolios regionally.
IMF Survey:Over the past six years or so, a number of primary listings have left the Johannesburg Securities Exchange (JSE), many for the London Stock Exchange. Indeed, the total number of listed companies fell from nearly 700 in 1999 to 420 by early 2004. Do you see this as a worrying trend?
Ahmed: The migration of primary listings to overseas markets reflects mainly the removal of exchange controls and a decision of some South African firms to compete globally for capital. Listings on overseas exchanges offer firms additional ways to raise capital on international markets and broaden their investor bases. The South African economy could therefore benefit from such developments.
Funke: We must put these developments in an international perspective. There has been a global trend of companies tapping overseas markets. Moreover, some of the delistings in South Africa occurred because of the stock exchange’s decision to remove companies that no longer met its listing requirements. Enforcing existing rules is important for credibility and corporate governance. And, recently, the JSE’s market capitalization has risen substantially, which is another indication that the stock exchange has not lost its attractiveness.
IMF Survey:What effect would the JSE’s proposed “pan-African board”—whereby large companies could be traded on a virtual African exchange—have on the composition and quantity of foreign portfolio investment to South Africa?
Ahmed: The proposed pan-African board aims to integrate all the participating countries’ exchanges, thus enabling brokers from member countries to trade any stock from any member country. A rigorous and broad-based implementation of a regional exchange or other forms of effective cooperation may reduce transaction costs and increase liquidity. This may lead to some increase in capital inflows, particularly equity inflows. It could also serve a catalytic role in improving the accounting and disclosure rules of other countries’ exchanges in the region.
IMF Survey:Could this pan-African exchange lead to capital flight from within the subregion toward the JSE, as Botswana exchange officials fear?
Funke: I do not see a risk of capital flight. In fact, quite the opposite may happen. Capital flows to participating countries may increase. If designed appropriately, the proposed regional exchange could help the other participating countries and companies operating in them raise capital more easily, and this new capital could be used to increase investment in the private sectors and economies of these countries.
IMF Survey:You argue that exchange rate volatility does not have a statistically significant effect on foreign portfolio inflows. But wouldn’t this volatility negatively affect foreign portfolio as well as foreign direct investment inflows, especially since sudden downward exchange rate movements could have a potentially negative impact on foreign portfolio investors’ remittances of dividends, capital gains, and/or interest earnings?
Ahmed: It is necessary to distinguish between depreciation and currency volatility. A depreciating currency over a longer period is very often associated with weak economic fundamentals, which makes a country less attractive for foreign portfolio and direct investment.
Funke: Exchange rate volatility tends to reduce a country’s attractiveness for FDI but, according to our results, does not have a significant effect on portfolio flows. Exchange rate volatility is associated with a lower share of FDI in total flows. One reason that portfolio flows are less affected by exchange rate volatility is that, because of the shorter investment horizon, portfolio investors may find it easier than FDI investors to hedge against currency risk. At the same time, some portfolio investors are comfortable with currency volatility because of the implied pickup in yield.
IMF Survey:Hedging can be costly. Isn’t this limited to the very large players who can afford to use hedging instruments?
Funke: Hedging may become expensive when nonstandardized instruments are used to hedge foreign exchange risk over long horizons. The cost of hedging is hardly a factor, however, when we’re talking about using more standard hedging products. And, yes, it is easier and less costly for larger investors to hedge risk.
Ahmed: For South Africa and a lot of other emerging markets, portfolio investment often comes from institutional investors who have access to various hedging tools.
IMF Survey:What policies could enable South Africa to attract more FDI in the future?
Funke: The South African authorities have, or are putting in place, a number of policies that should be conducive to increasing FDI inflows. For example, over the past few years, the central bank has increased international reserves substantially, which should help reduce exchange rate volatility. Macroeconomic developments are favorable, and the economy is growing at a brisk pace. These developments should help increase South Africa’s attractiveness as a destination for FDI.
Ahmed: South Africa has liberalized trade extensively since the early 1990s, and the Department of Trade and Industry is currently reviewing the trade regime with an eye to further liberalization. Additional trade liberalization would tend to attract more FDI.
Funke: Further liberalization of some remaining capital controls—notably, requirements that firms repatriate export proceeds within a prespecified time period—would also be a positive signal for foreign direct investors. And other policies not explicitly considered in our study, such as an acceleration of privatization, could be instrumental in increasing the share of FDI.
Ahmed: There are clear signs that foreign investors are increasingly interested in exploring opportunities in South Africa. For example, foreign banks have been expressing growing interest in gaining access to South Africa’s market. In recent months, Barclays has been in talks to acquire a majority stake in South Africa’s largest retail bank, ABSA.
IMF Survey:What impact, if any, do you see from South Africa’s membership in regional organizations—such as the Southern African Development Community (SADC) and the Southern African Customs Union (SACU)—and trade agreements negotiated with the European Union and other countries?
Funke: South Africa plays a key role in the region and is obviously very integrated with it. The government is currently reviewing or negotiating bilateral and regional trade agreements. Together with the review of the tariff regime, this should provide a very positive signal to foreign investors. Our findings suggest that trade openness is one of the most robust determinants of FDI.
Copies of IMF Working Paper No. 05/40, “The Composition of Capital Flows: Is South Africa Different?” are available for $15.00 each from IMF Publication Services. See page 136 for ordering information. The full text of the paper is also available on the IMF’s website (www.imf.org).